The Fall of Free Market Dogmatism

Last week’s warm spring weather brought the return of rolling blackouts to California. Since electricity demand is still expected to climb 50% over the next three months to its August peak, we may soon see something more significant than just localized personal and economic hardship in our largest state. There is a very real possibility that decades of American support for free market doctrine will also begin to melt away in the scorching summer heat. We may be approaching a political inflection point of historic proportions.

For decades, California has played the role of national trendsetter, with its huge population—now almost as large as New York and Texas combined—and its influential role as the home of both Silicon Valley and Hollywood. California’s late 1970s tax revolt propelled the national rise of Ronald Reagan, and the late 1990s political collapse of its Republican Party following the ethnically divisive campaigns of former Gov. Pete Wilson cautioned the national Republicans under President George W. Bush into making minority outreach an absolute centerpiece of their efforts.

Now this most technologically advanced portion of wealthy America may soon be reduced to Third World conditions. Analysts forecast hundreds of hours of statewide blackouts this summer, with direct economic losses in the tens of billions from these unpredictable outages. Nearly all major elements of the business community with huge Intel at the head have indicated they plan to suspend any future development in California until these reliability problems are permanently solved. Blackouts will occur despite estimates of a horrific ten-fold increase in overall statewide electricity costs, from $7 billion in 1999 to a projected $70 billion in 2001. The impact on the California economy may easily be enough to tip the entire country into recession.

The human cost may have an even greater public impact. Most of California is irrigated, air-conditioned desert, capable of supporting its 35 million residents only through modern technology. Densely populated portions of Southern California and the Central Valley regularly reach 100 or 110 degrees in July and August, and if the power goes off for extended periods, hundreds or even thousands of California’s oldest, youngest, and weakest residents may die, with the television news carrying a nightly death toll.

The universally-acknowledged cause of all this suffering and death—perhaps soon likely to rank as one of the greatest man-made catastrophes in American history—will be an electricity deregulation scheme, a seemingly innocuous plan to replace government control with market competition in order to provide increased choice and efficiency to consumers. Under this plan, California’s huge quasi-government public utilities such as PG&E and Edison were deregulated, deprived of their local monopolies, and required to divest their energy producing facilities to third parties, buying their power on the spot market instead. In return, these utilities demanded that their electricity costs be allowed to float while their prices charged to the consumer remain fixed at a high level. Since California had long had a large power surplus, and since market competition was expected to increase supply and lower prices, utility profits from this spread would be enormous. In fact, almost $20 billion of such surplus profits flowed to those utilities from 1996 through 1999, which they distributed as shareholder dividends and executive bonuses, or used to acquire facilities in other states or overseas.

Then, during 2000, wholesale prices for electricity began to rise sharply, transforming fixed retail prices from hugely profitable price floors into ruinous price caps, costing the utilities billions in losses and pushing them to the edge of bankruptcy. Although the initial rise in costs was probably due to normal market forces such as the booming California economy and increases in the price of the natural gas used to power the generator plants, suppliers may have suddenly realized the profit potential of a restricted supply.

The reason is simple. Having been crafted by special interests, the original 1996 deregulatory legislation threw consumers the single bone of guarantees against rate rises. Given these promises, politicians were terrified of suddenly breaking this compact, and allowing utilities to pass along large, sudden rate increases of 30% or 50%. Gov. Gray Davis, an exceptionally cautious career politician probably spoke for most of his colleagues when, despite the mounting crisis, he promised last February to prevent any significant rate increase and said “If I wanted to raise rates, I could have solved this problem in twenty minutes.”

But electricity use is highly inelastic, and only large, long-term rate increases will persuade consumers to make the new purchases and changes in lifestyle necessary to substantially reduce demand. As a result, the worst electricity crisis in California history has seen little drop in usage, despite massive media coverage and hundreds of millions spent by the state on promoting conservation.

With demand almost fixed, small drops in supply can produce huge increases in price, and electricity megawatt costs which averaged $30 in 1999 have recently peaked as high as $2000 on the spot market. Such potential profit margins produce considerable moral hazard. Most of California’s generating plants are now owned by a handful of Texas-based power companies, and their executives have a clear, fiduciary responsibility to maximize shareholder profits rather than to protect the interests of California consumers. Under the special conditions of the California market, taking a generator plant off-line for optional, unscheduled maintenance will sufficiently reduce supply that profits will rise enormously at other plants owned by the same company. Whether or not such alleged market manipulation is actually occurring, unscheduled generator shutdowns are up nearly 300% from 1999 while the wholesale cost of the electricity they produce has risen by over 800%. Similarly, a federal judge recently found evidence that the El Paso Corp.—which controls about 60% of the pipeline capacity into California—has deliberately restricted the incoming supply, producing markups on gas delivered to California almost twenty times greater than to other parts of the country. Such behavior would hardly have surprised Adam Smith, who regarded attempted manipulation by businessmen as an endemic problem for free markets.

Although Gov. Davis finally abandoned his promise to block rate increases, and supported an average rise of 35%, these prices will not reach the consumer for weeks, demand has dropped little, and wholesale prices still remain almost ten times greater than cost to the end user. During 2000, California’s giant utilities spent months bridging this huge expense gap, burning through around $14 billion of their balance sheet in the process and reaching the brink of bankruptcy. Since January, Gov. Davis has moved California’s government into that same doomed role, recently exhausting the entire state surplus of over $6 billion in the process, with no end in sight. In fact, cost increases have now caused the state’s daily burn-rate to rise from $40 million to as high as $150 million. But the political pain of accruing massive state debt or coping with future budget cuts is not as immediate and stark as the public reaction from immediately doubling or tripling rates.

Following deregulation, PG&E and Edison sold their generating facilities for a total of just $2.7 billion, and currently the California government is paying almost that much for power each month, mostly to the new owners of those plants. In their defense, power suppliers can fairly argue that part of their price reflects a risk premium against the very real possibility that they will never receive more than a fraction of the billions in past payments still due them by the bankrupt utilities. Some of the smaller energy suppliers withinCalifornia have already been driven into financial collapse by their inability to receive cash owed by the utilities, further reducing energy supply. With inelasticity of demand, little transparency, gigantic price swings, exorbitant profits, and huge payment risk premiums, California’s electricity marketplace has reached the point of almost complete breakdown more typically encountered by entrepreneurs in a Third World economy.

No easy solution is apparent. Although free market ideologues might suggest passing the full cost of electricity to the consumer, such a tripling of rates would surely cut demand, but probably at the cost of an unprecedented populist revolt. Democrats and now some Republicans propose capping wholesale profit margins at some reasonable level such as 40% (rather than the current 500% or more), but this is anathema to the deregulation advocates who dominate the relevant federal boards. Populist or leftist Democrats have suggested that the long-term solution is creating a state power agency, with seizing the existing power plants being realistically discussed as an immediate step.

The largely artificial nature of the electricity crisis is indicated by a few simple facts. Since 1996, overall California energy consumption has risen less than 10%, and with absolute peak summer usage having actually declined in 2000 from 1998 and 1999, now down to a level actually below the generation capacity ofCalifornia’s own plants alone. Furthermore, wholesale spot rates spiked by a factor of ten and blackouts began in January, a month when statewide usage was close to its annual low. Among the less suspicious causes is that many of the state’s smaller generators have now shut down through lack of payment, and other generators have previously signed long-term contracts, pledging their power to out-of-state recipients. As a result, California this year will probably spend ten times what it did on electricity in 1999, and still endure crippling blackouts.

Regardless of how or whether this desperate situation is resolved, deregulation may soon become a very dirty word to all Californians and many other Americans as well. Los Angeles and Sacramento both contain publicly owned utilities which were never deregulated, never sold off their generator plants, and as a direct result have inflicted neither blackouts nor large rate increases upon their residents. When the lights go out in deregulated Beverly Hills but stay on in surrounding public power Los Angeles, free market dogmas will begin to seem doubtful.

Prior to the onset of the Great Depression of the 1930s, free market capitalism reigned supreme in America, but its perceived failure to cope with that disaster opened the door to the New Deal’s program of governmental regulation, public ownership, and state planning. The following thirty years of prosperity completely marginalized advocates of laissez faire, until Goldwater’s disastrous 1964 campaign seemed to provide the final proof that libertarian opposition to the Tennessee Valley Authority was a passport into political oblivion. Then, suddenly, the Big Government disasters of the late 1960s and 1970s such as welfare programs, forced busing, and wage-and-price controls led to the rebirth of support for deregulation, privatization, and tax-cuts, with the presidency of Ronald Reagan serving as the battering ram for free market forces.

Our last twenty years of prosperity have now so established the intellectual dominance of market forces that they in turn have become almost unchallenged outside the political margins. Just as during the heyday of Big Government, Eisenhower Republicans made their peace with the New Deal and it was the Republican Nixon and Ford Administrations which enacted wage and price controls, America’s Clintonized Democrats have now thoroughly embraced balanced budget monetarism and even the most leftwing members of the California legislature eagerly voted for electricity deregulation.

But the political tectonic plates may be shifting once again. Free marketers may argue that the concept of deregulation should not be tainted by a single failed—and very poorly designed—deregulation scheme, but this defense will carry little weight if the lights go out and people begin to die. We must remember that support for Big Government was not brought down by the numerous successful programs like Social Security and the TVA, which have remained popular to this very day, but by the major failures of the Great Society, such as welfare. The greatest vulnerability of a sweeping ideological framework is at its weakest, most visible example.

Just over a decade ago, America faced a previous national deregulation crisis, of eerily similar characteristics. Just as with electricity, special interests exploited bipartisan political naiviete regarding the “magic of the marketplace” to partially deregulate America’s S&L industry, changing dull and obscure regulations to produce a heads-I-win-tails-you-lose structure which privatized investment gains and socialized investment losses. The disastrous incentive structure of that failed deregulation—and the ruthless exploiters it attracted—for a time threatened to bring down America’s entire financial system. But America and its deregulatory ideology successfully dodged that bullet. Now a second crisis, of similar proportions, is at hand.

I would be the first to admit that the vast majority of America’s many deregulatory efforts of the last few decades have been substantial, even dramatic successes. But an ideology which provides significant benefits nine times and horrible destruction on the tenth must be evaluated in a very cautious light.

Such rational evaluations may not even dominate the coming debate. During the Irish Potato Famine of the 1840s, British landowners used legally valid contracts to export large quantities of food while millions of Irish peasants starved. This summer, energy contracts of equal legal validity will mean that some of California’s own generators will ship their electricity to other states while California pays ten times the price, and hundreds may still die in darkness. If deregulation, market forces, and contractual absolutism abandon the largest state of the richest nation in the world to such a fate, I doubt that dogmatic free market doctrine will easily survive in America.